Capital Allocation for Insurance Companies - What Good is it?

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A.Read, Jr., propose to use a specific capital allocation method for pricing insurancecontracts. We show that in their model framework no capital allocation to lines ofbusiness is needed for pricing insurance contracts. In the case of having to coverfrictional costs, the suggested allocation method may even lead to inappropriate insuranceprices. Beside the purpose of pricing insurance contracts, capital allocationmethods proposed in the literature and used in insurance practice are typically intendedto help deriving capital budgeting decisions in insurance companies, such asexpanding or contracting lines of business. We also show that net present valueanalyses provide better capital budgeting decisions than capital allocation in general.